December Emerging Markets Debt Update

Monthly Commentary

The year was characterized by synchronized global growth and low inflation, both of which benefited Emerging Markets debt (EMD). The asset class was able to withstand higher U.S. rates as the Fed moved slowly and in line with prior guidance and the ECB and BOJ remained accommodative. Emerging Markets local currency debt outperformed dollar debt, returning 15.21%, followed by dollar-denominated sovereigns, 10.26%, and dollar-denominated corporates, 7.96%.

Source: Bloomberg; JP Morgan; Data as of December 31, 2017

Given the rally, we are often asked whether the Emerging
Markets (EM) trade is over, particularly in light of
developments in the U.S. (rising rates, tax reform, and foreign
policy uncertainty) and slowing Chinese growth. We believe
EM can continue to weather these various market risks
and benefit from continued inflows in light of improving
fundamentals, attractive relative value versus developed
markets and supportive technicals. Our view is predicated
upon the following:

The synchronous global growth story continues, directly
benefiting EM through improved trade and a stronger
commodity-price environment. In addition, growth has
been broad-based, rather than concentrated in a small
number of countries. Growth potential for EM sovereigns
is also significantly ahead of developed markets with the
spread between EM and developed market (DM) growth
likely to increase for the second year in a row.

Growth in China surprised on the upside during the first
half of 2017, and while second half data indicates slowing,
the tail risks appear to have subsided as capital outflows
have stabilized and exports have increased. Furthermore,
authorities continue to focus on reducing risks in
the financial system, with an emphasis on increasing
borrowing rates and reducing shadow-bank lending. We
expect full year 2017 growth to be approximately 6.8% and
estimate growth in 2018 to slow to 6.3%.

At the time of the 2013 taper tantrum, EM growth was
slowing and much more vulnerable to Fed normalization.
From 2013-2015, however, EM went through a notable
adjustment period, implementing important structural
reforms and reducing current account deficits. EM growth
is increasing and the widening spread between EM and
DM growth typically has had positive implications for both
foreign direct investment and passive investment flows.

Real yield differentials between EM and DM are closer to
the wide end of the range over the last five years. While we
believe that this spread will continue to compress in 2018,
it should remain wide enough to continue to support
inflows, even as the Fed continues its slow and welltelegraphed
pace of rate hikes.

In addition, inflation has fallen to low single digits on
average, and fiscal conditions – for the most part – have
improved. And while we expect inflation to moderately
increase in 2018, we do not anticipate that it will be a
significant headwind in light of negative output gaps in
most major EMs.

EM is in the late early-to-mid stage of its current business
cycle, which differs from the U.S., which is arguably late
stage. EM corporates continue to demonstrate robust
earnings growth (although at a slower pace than in 2017),
and there are clear signs of continued deleveraging.
Corporates are also increasing capital expenditures,
which suggests comfort with the growth outlook and
demand prospects. While 2017 was a record year for gross
issuance, the bulk of this represented refinancings, tenders
and buybacks with net new issuance a restrained $141
billion. In addition, the EM market tends not to fund lower
rated CCC credits. In fact, CCC issuance is nearly 0% of
supply in 2017, which compares to 33% for U.S. high yield.

EM fixed income now represents approximately 16% of
global fixed income. Despite approximately $110bn of
inflows in 2017, most investors remain underweight. We
expect technicals to remain supportive in light of this
underweight, and continue to see investor interest to add
exposure to the asset class.

As for valuations, with average yields of 5-6% (with the
potential to capture more in select markets), valuations
remain attractive versus developed markets, particularly
considering that close to 60% of global fixed income trades
below 2%. We remain constructive on EM dollar-denominated
debt, given cyclical and structural tailwinds. We certainly have
to acknowledge that spreads have tightened significantly
as inflows have increased. EM sovereign spreads tightened
around 60 basis points (bps) in 2017 and are around 90
bps inside long term averages. That said, the pickup over
developed markets debt remains attractive. EM sovereigns
benefit from minimal supply, and EM corporates currently
trade 40-60bps above similarly rated U.S. credits. We believe
that carry will represent the bulk of returns in 2018, supported
by spread tightening in select higher growth markets and
offset by higher U.S. rates.

We continue to see EM local currency debt as providing
the greatest return potential in EMD over the next 12
months. Approximately 65% of the local currency index is
rated investment grade, and the pickup in growth has helped
stabilize ratings downgrades. In addition, average yields in
local currency debt are around 6%, with the potential to pick
up higher carry in select markets. Plus, a variety of short and
long-term currency valuation metrics indicate that EMFX
is undervalued relative to the dollar. We see potential for
currency gains, as EM currencies are still down over 25% on
average since mid-2013. The dollar appears to be peaking, and while there certainly may be periods of dollar strength, we do
not see the case for a sustained and continued dollar rally,
especially considering the fact that EM growth is outpacing
U.S. growth. And keep in mind that even a moderate FX
catch-up of 10% over the next year would serve as a powerful
‘kicker’ on top of high carry. We would look for opportunities
to buy on weakness.

Our base case for 2018 is predicated on a synchronous global
recovery, modest upside in inflation and a gradual removal of
monetary accommodation. We see the risks as follows:

Inflation/Rising U.S. Rates: As mentioned, inflation in
EM remains benign and is expected to slightly increase
next year from low levels. However, any meaningful and/
or unexpected pickup in U.S. inflation that forces the Fed
to hike more aggressively will likely weigh on fixed income
markets (not just EMD).

Idiosyncratic Risk: There are over 10 elections in
Emerging Markets next year, including in larger countries
such as Brazil, Mexico and South Africa, which could
both contribute to heightened volatility and present some
economic growth downside depending on outcomes.

U.S. Policy: Changes in U.S. policy could present both
growth and geopolitical risk.